A friend told me that economist Charles Kindelberger had two rules for a credit economy. Rule 1 was everybody should know that if they get overextended they will not be bailed out. Rule 2 was that if everybody gets overextended they must be bailed out. The US economy has overextended itself, triggering rule 2. But that still leaves open how a bailout should be designed since designs are not all equal.

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Currently, two models are on the table. One is the Paulson model (also supported by Ben Bernanke) that proposes government buy the bad assets of financial institutions. The other is a Buffett-style recapitalization model that would have the government invest in and recapitalize banks, just as Warren Buffett has done for Goldman Sachs.

The underlying problem is that the financial system is short of capital owing to massive asset depreciation. This shortage is impeding provision of credit, which threatens to tank the economy by interrupting normal commerce.

Banks are caught in a pincer preventing them from raising capital. On the one hand, if they sell assets to cleanse their balance sheets and make themselves attractive to investors, this could cause large losses as to trigger bankruptcy. On the other hand, uncertainty about bank worth means the market is demanding such onerous terms for fresh capital that banks are unable to meet them.

Reading between the lines, the Paulson plan appears to propose that the government buy securities through a “reverse" auction whereby banks (and other firms) offer to sell assets to the treasury at a price of their naming, and the treasury accepts those offers meeting its acceptable price. Implicit in the treasury’s thinking is the assumption that the market will recapitalize banks on reasonable terms once they are cleansed.

The essence of the plan is that financial markets have been hit by massive fear-based price disruption, requiring the government to create a new market to break the logjam. If correct, by purchasing assets at distressed prices and holding them to maturity, taxpayers could eventually make a profit, making the bailout costless.

The recapitalization model completely sidesteps cleansing banks and, instead, has government directly recapitalize them. It can do this by buying compound cumulative preferred stock from banks, and also taking warrants that give an option to buy common stock in future at today’s low price. That way, if all works out, taxpayers are rewarded for the risks they take today.

Since preferred shares rank above common shares, existing shareholders would be hit before taxpayers, should there be future unexpected losses. Meanwhile, taxpayers would get the benefit of the preferred stock dividend. Furthermore, if banks suspend dividend payments, the suspended dividend will cumulate and compound so that taxpayers ultimately recoup delayed payments.

Recapitalizations can also be accompanied by other useful provisions, including restriction of dividend payments on common stock. Additionally, banks could sign a memorandum of understanding with the Fed suspending capital standards and mark-to-market asset price accounting. Both of these practices have squeezed banks by causing further losses as asset prices fall. Since markets are not working well by the treasury’s own admission, it makes no sense to keep using market price accounting.

The Paulson plan is subject to three fundamental criticisms. First, the treasury may overpay for assets, saddling taxpayers with large losses. If the treasury sets its acceptable price too low, there is a risk it will buy insufficient assets and banks will not be cleansed. If it sets prices too high, the risk is the treasury overpays. Second, the treasury is taking a big risk as prices could fall further, yet it is not being properly rewarded for this risk-taking. That is tantamount to subsidizing banks which have created the mess. Third, markets may not provide finance even after the treasury’s purchases, in which case banks will remain undercapitalized.

The Paulson model’s defence is that taxpayers are protected by the reverse auction design. Banks need money and will, therefore, offer assets for sale at true worth, knowing they may be undersold by other needy banks if they ask for too high a price.

Criticisms of the recapitalization model are twofold. First, what price should the treasury pay for preferred stock? Second, which banks should get funding? The danger is that zombie banks apply for funding, seeking to save themselves by gambling for redemption with taxpayer money.

The recapitalization model’s defence is that accounting information exists, due diligence can be conducted, and judgement can be exercised when it comes to setting warrant prices and interest rate terms on preferred shares. Indeed, due diligence and judgement are also needed under the Paulson plan to establish the maximum price government will pay for different securities.

The reality is that there are two fundamentally different models for addressing the financial crisis. Both have strengths and both have weaknesses. Time is needed to deliberate on them, and Congress should not be stampeded into a decision. Nor should Congress hand over a $700 billion blank cheque, particularly to the Bush administration in its waning days.

Finally, both the Paulson and recapitalization models deal only with the supply of finance. Neither deals with the problems of reregulating finance, jump-starting the economy, and ensuring the economy delivers shared prosperity that escapes the trap of relying on debt and asset price inflation to drive growth.

Edited excerpts. Published from www.thomaspalley.com with permission. Thomas Palley is founder of Economics for Democratic and Open Societies. Comment at theirview@livemint.com